Seeding inflation

PORTFOLIO POINT: With wages growth fuelling consumer spending, inflation is set to rise. Investors should seek out some inflation protection.

Readers may remember my article of July 30, Prepare for a cash crash, when I made the point that inflation was set to rise – nothing urgent, but the trough was either close or had been reached. Certainly this is a theme that other Eureka contributors, Elizabeth Moran, Robert Gottliebsen and Doug Turek have written up on as well.

Unfortunately Australia’s latest wage data backs this case strongly. Now it should be said that the quarterly wage numbers don’t usually elicit much market interest and that’s fair enough, as movements either way are typically quite slow. The series is generally more stable than other data points, in other words.

Yet we find ourselves in unusual circumstances, to the extent that economists and commentators can’t even agree about what should be the stylised facts – or rather, the observations that should be widely regarded as being true. To that end, last week’s Australian wage numbers contain a number of extremely important signals.

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It’s not that wage growth is surging into dangerous territory or signalling a sharp up-tick in cost-push inflation. No, this isn’t the case at all. The Reserve Bank usually only gets concerned when wage price inflation is 4.5% and over. But take a look at chart 1. Last week’s wage data shows the differential between wage rates and inflation is at very high levels – the highest since the series began. The chart also shows that this situation tends not to last very long.

Indeed, there have only been three previous episodes over the last 15 years or so where this differential has approached or breached the upper bound and, in each case, the differential normalised within a year.

Here’s the catch though. In each episode, we’ve found that the differential has normalised with inflation spiking back up. In the period over 2001-02 there was a bit of both, but the differential crashed through the lower bound. Besides which, in that instance, the unemployment rate spiked up as well, and, it is true to say that generally wage inflation rarely takes a sustained dip unless the unemployment rate is rising rapidly. This is what happened during the GFC, as you can see in chart 2 (below).

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What the data is showing then is that the incredibly low CPI outcome that we saw in the June quarter , of 1.2%, is not likely to last long. It makes sense right? A 3.7% wage rate may not be excessive, but it is inconsistent with consumer price growth of 1%.

But, as chart 2 also shows, in the absence of a material lift in unemployment, wages don’t seem to moderate. Fair enough that most Australian economists have been forecasting a lift in unemployment, and if it does lift the game changes.

Yet they’ve been doing this for some time and, as yet, it hasn’t happened. Indeed, as it turns out, the unemployment rate has been stable for nearly two years at 5.2%. So I’m not sure that we can really rely on a sharp lift in the unemployment rate to bring wages and inflation down, especially with domestic demand running well above trend and at a five-year high. All of this supports the recommendation I made in my July 30 piece, which was to look into some inflation protection now while it is comparatively cheap.

So that’s the first point. The second important point is that rising wages ensure that consumer spending will remain robust. It helps to ensure the sustainability of spending.

This is an important point, because there is a view in the market that soft consumer confidence, an update on which we saw last week, would mean that strong consumer spending wouldn’t or couldn’t be maintained. I don’t think this is quite right given what we’ve seen with the wage data and employment data.

Now when we’re talking about how much money consumers have to spend, we can’t use the wage price data that I referred to above. We can, however, use another wage series that was out last week called average weekly earnings. It may not be as good in determining rising wage pressures, but it is better in determining just how much it is consumers actually have to spend. So let’s have a look at that.

At the beginning of 2012, there was around 11.4 million people employed, who earned an average annual wage of something like $70,000. So that’s annual income of $800 billion. In nominal terms then, with wage growth of about 4%pa and if employment growth continues on its current trend-like trajectory – or about 15,000 per month – then by year end we’ll have 11.6 million people employed (for an increase of 200,000 people), earning just under $73,000. That’s total income of just under $850 billion, or a 6% annual gain in total consumer income, 4% wage growth and 2% (or there abouts) employment growth. 

Now a 6% increase in nominal incomes isn’t great by any means. You can see in chart 3 below it’s actually about 0.75% or so below the average (6.75%).

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However, if you throw in the current very soft inflation rate – with headline inflation likely to still be in the region of 1.5-2.5% by year-end, that means real wage growth of about 3.5-4.5%, which is very strong as you can see on the chart 4 below.

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On the back of those soft inflation numbers, real wage growth has spiked higher already and currently sits at about 5% year-on-year. This is very strong and the current wage and inflation trajectory for this year suggests only a slight moderation. This will certainly underpin continuing strength in household consumption over the coming year.

Note that in each period where real wage growth has exceeded 3.5% – late 1996-97, late 1999, 2003-04 and 2007 periods – consumer spending has always surged. So strong real wage growth is a very strong predictor of consumer spending, which is why I don’t think it is correct to argue that we will see spending growth rates moderate. It just doesn’t make any sense. So for investors, I wouldn’t place too much faith in repeated calls for consumer spending weakness.

In summary, it’s not usual for the wage data to contain such important signals on the Australian economy. However the difficulty that most economists and commentators are having in “now-casting” (as the RBA governor referred to it), or determining what is happening now as opposed to forecasting – and the sheer magnitude of some of the discrepancies – shows there are some very important signals for investors.

Firstly, it supports the already strong evidence that inflation will pick-up over the next year, perhaps quite dramatically. And secondly, strong real wage growth suggests recent strength in consumer spending is sustainable.